Can You Claim Insolvency for Credit Card Debt Settlements?

A credit card debt settlement is the result of negotiation between you or your representatives and a credit card company. If it appears that you are unlikely or unable to pay back the amount you borrowed, your creditor may agree to a lesser total payment in exchange for a one-time, upfront payment. If you are insolvent at the time of the settlement, you may be able to claim insolvency to help avoid taxes.

Taxation

If you have won the battle in your credit card negotiation and settled your debt for a fraction of what you owe, you may have to face the battle of taxation. Unlike the bankruptcy discharge, which can eliminate your debts without having to incur a tax liability, debt settlement typically results in the taxation of the forgiven amount. The IRS rationale behind this taxation is that you were essentially handed free income that you don't have to pay back, so that meets the definition of income.

Insolvency

In its simplest form, insolvency means that the total value of your debts exceeds the total amount of your assets. However, legally speaking, insolvency is a tricky matter, and you may want to consult an accountant or tax attorney to fully understand the details. Insolvency is not an all-or-nothing proposition; rather, you are only insolvent to an extent. For example, if you have debts of $50,000 and assets of $25,000, you are insolvent only to the extent of that $25,000. This is an important distinction because if the amount of your settled debt is greater than the amount of your insolvency, you still owe tax on the excess amount. In this same example where you are insolvent to the extent of $25,000, if your creditor settles debt in the amount of $40,000 you still owe tax on the excess $15,000.

Form 1099-C

Form 1099-C reports that amount of your debt settlement to the IRS, and you should receive a copy as well. If you had received a discharge of your debts, your creditor would have marked box 6 as showing your debt discharged rather than merely cancelled or settled. However, as the result of a settlement, you must report this amount as "other income" when you file your taxes.

Form 982

If you have a legitimate case for insolvency, you can make your claim on Form 982. This form allows you to remove any income from debt settlement to the extent that you are insolvent. For example, if you are insolvent to the extent of $5,000, you can enter $5,000 as the amount to be removed from the income listed on your 1099-C.